Feltex decision will provide comfort to the diligent director

The emphatic rejection by the District Court of all charges against the “Feltex Five” is a useful reminder of the protections the law offers directors provided they have been diligent in the discharge of their duties.

The rider is important. The facts show that the five - John Feeney, John Hagen, Peter Hunter, Tim Saunders and Peter Thomas – were painstaking in executing their responsibilities as directors but relied on what was later found to be incorrect advice from professional advisors on whom they were entitled to rely.

In fact, so impressed was the Court by the directors, that the Judge described them as “all honest men” who had “conducted themselves at all times with unimpeachable integrity” and went on to state that there was not “one skerrick of evidence to suggest any intention by them to mislead the regulatory authorities, market, shareholders, creditors, potential investors, or any other person”.

Such full-bodied language is rare in a judgment and must be interpreted as a rebuke to the Ministry of Economic Development (MED) for taking the litigation. Others have also criticised MED for regulatory over-reach and it must have been a line call decision to take proceedings. On the other hand, vigorous enforcement in appropriate cases is necessary to maintain public confidence in the regulatory framework – especially where investors have lost money.

The directors were charged with failing to disclose that Feltex Carpets Ltd had breached a financial covenant with the ANZ and with failing to classify the ANZ facility as a current liability when the effect of the breach was that the ANZ could call the loan in.

Both charges related to the release of the company’s half year results on 20 February 2006.

The men did not dispute that the statement failed to comply with applicable reporting standards under the Financial Reporting Act 1993 (FRA). Instead they relied on the statutory defences provided by section 40 of the FRA and by section 138 of the Companies Act 1993 (CA).

Section 40 of the FRA provides that it is a defence if the directors have taken “all reasonable and proper steps” to ensure that the requirements of the Act have been met.

Section 138 of the CA provides that a director may rely on information and advice prepared by, among others, “a professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person’s professional or expert competence”. This defence applies only if the director:

Acts in good faith; and

Makes proper inquiry where the need for inquiry is indicated by the circumstances; and

Has no knowledge that such reliance is unwarranted.

Feltex had embarked on a rescue mission to turn the business around in 2005 and negotiated a new loan with the ANZ to finance the restructuring which included the closure of a factory in Melbourne. The board was aware that the additional borrowing would put Feltex in breach of its existing banking ratios unless the ANZ granted a waiver or renegotiated the way the ratios were calculated. But correspondence from the ANZ, produced in Court, gave them every reason to assume that the bank would continue to support the company. It was only in late March that the relationship deteriorated, well after they had reported their interim results.

At the time the financial statements were being prepared, New Zealand was moving from GAAP to the New Zealand equivalent of International Financial Reporting Standards (IFRS). Feltex was one of the first New Zealand companies to make the move, and this was its first experience with the new system. The directors recognised the complexity of the task and had put in place a comprehensive strategy to manage the transition.

“They took these steps not because they were seeking to protect themselves but in order to promote the interests of the company by ensuring compliance with the FRA in this new and challenging accounting standards environment,” the Judge said.

This included:

commissioning Ernst & Young to prepare an IFRS assessment identifying the key areas that had to be addressed

establishing a steering committee comprising Feltex’s own financial management supervised by Ernst & Young to review the IFRS standards applicable to Feltex, and

engaging Ernst & Young to review the half year accounts to ensure they complied with the IFRS.

“A reasonable director having read Ernst & Young’s review report and attended the (board) meeting on 16 February 2006 would have been left in no doubt that the interim financial statements complied fully with the IFRS,” the Court said.

But the Judge held that Ernst & Young had been incorrect in advising that the treatment of liabilities between the GAAP and the IFRS amounted to “a change in terminology only” whereas in reality the difference was profound.

GAAP which, as the Court observed, “had prevailed during the professional lives of these directors up to this point”, favoured a substance over form approach which allowed them to act not on what the ANZ’s strict legal rights were but on their expectations of what the ANZ would actually do.

Under IFRS, the position was much more black and white. For a loan to be classified as non-current now required an unconditional right to defer settlement for at least 12 months after the balance sheet date – not simply an expectation, however justified, that the debt would not be called in.

“The IFRS are highly complex and presume an in-depth knowledge of accounting principles. These directors were entitled to seek and rely upon specialist advice. Ironically, it seems clear that the company’s specialist advisers were themselves judging the financial statement by reference to the requirements of the previous standards rather than the requirements of the new standards. That is the single most important reason why the directors have ended up having to face this prosecution,” the Court said.

The Court also dismissed nine additional steps which MED asserted the directors should have taken. These included looking at the IFRS personally and, in the case of Feeney, Thomas, Sanders and Hunter, asking Hagen (who had previously practised as a chartered accountant, although never as an auditor) to interpret the standards for them.

The Judge said that this assumed that the directors were not entitled to rely on professional expert advice and “had to do it themselves”. To accept that proposition would belie the whole purpose of the protections under section 138CA.

The not guilty findings should provide comfort to all directors that they will not be penalised for decisions taken after prudent consideration and on the basis of expert advice.

Roger Wallis is a Partner at Chapman Tripp specialising in securities and corporate law.